Legal Briefing

Corporate & Commercial | 09 December 2015

Being a boss of an SME has been likened to a plate juggler having to be constantly alert to what is happening in all parts of the business and ready to take swift action to avoid smashing the company crockery.

Managing the business in the ordinary course and dealing with matters as they arise (to quote a former Secretary of State ‘the known unknowns’) is bad enough but to cope with the ‘unknown unknowns’ is truly a nightmare.

Consider the case of Mr Sebry (Sebry v Companies House & anor [2015]) who was the managing director of a company called Taylor and Sons Ltd.

The company had been in existence since 1900 and was well established as a steel fabricating business with substantial customers including Corus (now Tata Steel). Unbeknown to Mr Sebry or anyone else in the company, in a different part of the country, a company operating a different business was experiencing financial difficulty which resulted in a winding-up order being made against it. That company was called Taylor and Son Ltd and, in the normal way, the Court’s office gave notice to the Registrar of Companies that the winding-up order had been made and the company was in liquidation. Unfortunately, the Court’s office omitted to include the company registration number in the notice to the Registrar and, even more unfortunately, an official at Companies House mistakenly filed the notice on the register for Mr Sebry’s company and not the one actually in liquidation. Mr Sebry was blissfully unaware of this until he was called by the Official Receiver who informed him that he was now the liquidator of his company.

Mr Sebry took immediate action and it was soon discovered how the error had occurred and the Registrar of Companies agreed to rectify the register.

Unfortunately rectification took some days to arrange and in the meantime the erroneous message that Taylor and Sons Ltd was in liquidation had been widely disseminated via various subscription services such as Experian, Dunn & Broadsheet and the like.

In a matter of days Mr Sebry saw bank and other credit facilities cancelled and key contracts terminated. The business was suddenly in severe financial distress and was forced to cease trading and go into administration.

Mr Sebry sued the Register of Companies and in a hearing earlier this year a judge held that, while the Registrar was not in breach of his statutory duty under the Companies Act, he did have a duty of care under common law and was in breach of that duty. The judge pointed out that no-one else was involved in the filing process and it was quite foreseeable that if a company is wrongly stated to be in liquidation on the register it could suffer serious losses and, in this case, ‘the destruction of a company which had traded for over 100 years and which owned a valuable business’.

The Registrar is appealing against the decision with an appeal hearing expected in early 2016 but, if the judgment is upheld, damages in the region of £8m are anticipated.

The case is also a cautionary tale to lawyers, accountants and insolvency practitioners who regularly file notices in relation to insolvency proceedings with the Registrar. They will also owe a similar duty of care and a mistake in a company’s name or number could have equally disastrous (and expensive) consequences.

If awarded, damages may be some comfort to Mr Sebry but no doubt he, the employees who lost their jobs and creditors would wish that the situation had never arisen and that the company had continued its successful business.

He might also ask how he could have protected himself from this particular ‘unknown’. In truth, there is nothing that would have been done to eliminate the threat altogether, but there are strategies and structures which businesses can adopt to contain damage. Considering these is a key part of good corporate governance and, as described below, is a requirement for quoted companies.

One simple, prudent step, which might have helped Mr Sebry would have been to make use of the Companies House service which gives an immediate e-mail alert when any filing is made in relation to the company. Some days passed before Mr Sebry became aware of the disaster which was to strike and perhaps something could have been saved if action had been taken more swiftly.

Perhaps, in addition, having a culture and systems imbedded in the company which are designed to recognise potential risks and to deal with damage limitation might also have lessened the effects of the Registrar’s error.

For public companies whose shares are listed on the London Stock Exchange the requirement to have such systems in place has been a requirement for many years. In 1999, the ground-breaking Turnbull report explained the importance of risk management and the sort of systems that companies should adopt. The recommendations of the Turnbull report were incorporated into the Combined Code of Corporate Governance (the Code) and have been refined and updated several times over the years, the latest variation being in 2012. Alongside the Code, the Financial Reporting Council (FRC) publishes guidance on the implementation of the Code and the nature and extent to which a company policies should be a matter of report to shareholders. The latest such guidance was issued in September 2014 with the title ‘Guidance on Risk Management, Internal Control and Related Financial and Business Reporting’.

Of course, full implementation of the Code and the recommendations of the FRC would be impracticable for most companies other than those listed on the Stock Exchange but many of the principles and systems, as well as the culture for dealing with risk, could be adopted by smaller enterprises and be of real benefit in assisting such businesses in anticipating and dealing with the ‘known and the unknown’ risks. The following sets out some suggested areas where the Code and the FRC guidance may provide useful pointers.

THE OBJECTIVES OF RISK MANAGEMENT POLICY

It is important that those controlling the direction of the company be aware of their duties and responsibilities in relation to the management of risk. The Code defines such role as follows:

‘… to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed.’

The FRC guidance goes on to explain:

‘… effective development and delivery of a company’s strategic objectives, its ability to seize new opportunities and to ensure its longer term survival depend upon its identification, understanding of, and response to, the risks it faces.’

THE CULTURE OF RISK MANAGEMENT

In 2011 the FRC published a report on board responsibility in relation to risk and in 2012 the Sharman Inquiry into going concern and liquidity risk also considered the culture to be adopted within the company’s structure. These reports stressed that risk management and internal control should be incorporated within the company’s normal management and governance process and not be treated as a separate compliance or ‘box-ticking exercise’. The reports also recognised the importance of the assessment and management of the principal risks and the monitoring and review of the associated systems. The reports also stressed that these should be carried out as an on-going process and not seen as an annual one-off exercise at the financial year end.

RISK ASSESSMENT AND RISK APPETITE

The FRC guidance summarised the reports’ conclusions on the importance of risk assessment as follows:

‘… the board must make a robust assessment of the principal risks to the company’s business model and ability to deliver its strategy, including solvency and the liquidity risks. In making that assessment the board should consider the likelihood and impact of those risks materialising in the short and longer term.’

The FRC guidance also highlights the importance of the board:

‘… determining the nature and extent of the principal risks faced and those risks which the organisation is willing to take in achieving its strategic objectives (determining its “risk appetite”)’

When considering the sad case of Mr Sebry and reading the guidance set out by the FRC, I was reminded of some of the financial disasters which have befallen companies I have known over the years and was struck by the extent to which those disasters might have been avoided if proper risk management and assessment procedures had been in place. The following true ‘horror stories’ may illustrate the point (the names have been changed to protect the guilty).

‘MICROCO’

Microco was the brainchild of some computer experts and was formed to exploit some new technology that the inventors believed would conquer the world. Microco were successful in raising money on one of the secondary markets but, like so many companies before, discovered that the path to production and sale of product was much longer and more expensive than anticipated. As a result Microco soon began running out of cash.

Rather than addressing the problem at board level, the company delegated ‘cash management’ to a junior in the accounts department. As the crisis deepened the flood of writs and demands increased and the accounts junior filed these in date order with a diary reminder to pay just before the matter came to court. Unfortunately, he failed to realise the significance of a winding-up petition and merely made a diary note for payment on the day before the petition was due to be heard. As required by the process, the petition was advertised around ten days after service on Microco and at that point the bank accounts of the company were frozen causing terminal failure.

There was a failure to address risk by the board of Microco at many levels. The cash flow projections upon which the fundraising had been based were unrealistically optimistic and a more rigorous approach would have shown the need to raise further funds and build in safety margins. As the crisis developed, the matter should have been addressed by the board, which should have realised that without radical action failure was almost inevitable. Delegating cash management to a junior in the accounts department was an abrogation of their responsibility to tackle the risk facing the business and, in the subsequent liquidation of the company, the directors were rightfully pursued for continuing to trade and incur credit when they should have realised that the company was facing an imminent insolvent liquidation.

‘BEDCO’

Bedco was a family owned business which operated a successful hotel/apartment business in central London. A substantial amount of family money had gone into the refurbishment of the building and the business only required a modest amount of funding to provide its working capital requirements. With excellent security cover the company’s high street bank was more than willing to help and, in fact, the bank manager went an extra step and offered Bedco an interest rate protection scheme. The bank manager explained that it came at little cost and protected the company against interest rate increases by capping the maximum amount payable. Bedco barely looked at the document having been assured that it carried no risk and thanked their bank manager for his thoughtful and prudent advice.

When the world economy stopped following Lehman and the other banking collapses, interest rates fell to record lows and it was only then that the terms of the interest rate ‘protection’ were looked at. For reasons that it is hard to understand, the instrument provided that if interest rates fell below a certain level the rate of interest payable on the working capital facility would immediately rise to the highest level at which interest rates would be capped. Suddenly, Bedco found that it was paying interest at a rate three or four times more than rates available in the market and that such costs made the business model look unsustaintable. They sought to terminate the arrangements but were informed by their (now less than friendly) bank that the costs of breaking the arrangement would be enormously high. Bedco’s business began to struggle and the bank appointed accountants to carry out an ‘independent business review’. The accountants concluded that as a result of the costs of the interest rate instrument the business was not sustainable and recommended the appointment of administrators. The administrators (from the same firm who had carried out the review) declined the request by the directors to seek recourse against the bank on the grounds that the company had been mis-sold the interest rate product.

The failure of the board of Bedco was obvious. They had not scrutinised the terms of the interest rate instrument and its potential effects. Before entering into any long-term agreement, directors should consider all implications and costs and, where appropriate, take appropriate advice. In this case even a cursory examination of the interest rate documentation would have made it obvious that where interest rates fell it became extremely toxic.

‘CARPET CO’

Carpet Co was a well-known carpet manufacturer of international renown exporting product to many countries including the USA. A US customer failed to pay Carpet Co for a substantial order and, on the advice of its English and US lawyers, action was commenced in US courts. The litigation was extremely costly and time consuming but the advice of the lawyers was that Carpet Co had a good case and, indeed, it ultimately obtained a substantial judgment together with costs in its favour. The US company immediately filed for bankruptcy and Carpet Co itself was forced into insolvency as a result of the unpaid debt and the even more substantial legal fees they had incurred.

The risks attaching to litigation should never be underestimated particularly, as once embarked upon, it is difficult to escape the process without enormous cost. The risks should be carefully evaluated and wherever possible minimised by such things as litigation insurance or contingent fee arrangements with lawyers. It is also sensible to make sure that if another party is to be sued that such party has the ability to pay the amount claimed.

‘DARWIN CO’

It is hard to see how the directors of Darwin Co should have assessed the risk facing the company as, in this case, that risk was their own profound stupidity.

Based in California, Darwin Co was a newly appointed dealer for a luxury brand of motorcar. The brand’s US headquarters were astonished by the extraordinary number of sales that Darwin Co achieved in its first few days of trading and called the management to ask what had been the key to their amazing success. Darwin Co’s manager proudly announced that he had got the idea from a nearby coffee shop which had opened with a promotion based on ‘buy one get one free’. He had figured that the same approach could apply to selling luxury motor vehicles and his hunch had proved to be entirely correct. It is understood that the boss of Darwin Co was rather hurt and offended by the reaction of the brand HQ and never did comprehend why his brilliant idea had resulted in such spectacular failure. Perhaps, in his case, he was one risk that could not have been anticipated.